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On Thursday, April 15, Gary Gorton joined Markus’ Academy for a lecture on “Recent Changes and the Future of the US Financial System”. Gorton is the Frederick Frank Class of 1954 Professor of Finance at the Yale School of Management.

Watch the full presentation below and download the slides here. You can also watch all Markus’ Academy webinars on the Princeton BCF YouTube channel.

Executive Summary

  • The financial crisis has not been solved because financial crises are inherent in market economics. A financial crisis is always about runs on short-term debt, e.g. in the repo market. The general trend in the past couple decades has been a decline in deposits replaced with other short-term debt instruments like repo contracts. 
  • There are fundamental changes in the economy — banking is moving out of the regulated sector. Bank loans are flattening in terms of GDP and other financing methods are growing. Increased regulation has increased the cost for repo, resulting in the rise of sponsored repo which reduces cost and shifts risk to FICC. There has been an increase in FHLB overnight debt, substituting for repo. With COVID-19, the maturity of commercial paper issuance has been shortening, similar to what happened during the GFC. 
  • Money market mutual fund reforms have driven retail funds out of existence, which has led to a rise of variable denomination floating rate demand notes. These notes are similar to a money market mutual fund but are not transferable. They have both financial and non-financial issuers. 
  • Stablecoins, like tether, have been able to maintain a price at 1 and seem fairly successful. Stablecoins are money that have a one-to-one ratio with cash and are redeemable and transferable without interest. Since they don’t pay interest, they must have a convenience yield, which may include trading cross-border, payments, remittance, and payrolls. Stablecoins are still connected to the banking system as they put their money in the banks. 
  • Stablecoin is essentially unregulated free banking that issues deposits. However, free banking never worked in the past, even in cases whether the government required backing. There needs to be credible backing for Stablecoin as they are now runnable without any entity overseeing them. 
  • There are several challenges to Stablecoin. The transformation of the financial system takes time, up to decades. Thus, these transformations should be followed by regulators and need to be considered to regulate transnational technologies. 
  • The fundamental theorem of bank regulation stipulates that bank regulators can only decide the location of the banking system. Without carrots — or incentives — to keep a bank, they can move, as evidenced by the rise of mortgage and loan origination outside of the banking system given the high costs of staying a bank.